Why Chinese Stocks Are Alluring

By

Wei Gu

Updated May 9, 2013 11:46 p.m. ET

A typical Chinese family owns too many bricks and not enough stocks. With Chinese stocks looking cheap compared with their history, and as property prices continue their years-long surge, now might be a good time to make a switch.

Chinese stocks are now the second-cheapest in the region and are trading at a 27% discount to their historic average. The WSJ's Deborah Kan talks to Wei Gu, China wealth editor, about why investors should take a look at Chinese equities.

A common investing mistake is being overweight in assets that have done well recently. China was the world's top-performing real-estate market from 2008 to 2012, according to consultancy Knight Frank.

Many stock-market investors, meanwhile, have suffered big losses, so it isn't surprising that sentiment and valuations are low. Only 22% of families who have invested in stocks have made a profit overall, while 56% have lost money and 22% have broken even, according to a 2012 household-finance survey by the People's Bank of China.

The best investors are the ones who question their own decisions and listen to skeptics. The worst credit their own brilliance for gains made in a rising market. At Berkshire Hathaway's annual meeting last weekend, Chairman Warren Buffett invited a hedge-fund manager who is betting against Berkshire stock to ask him questions. Chinese investors need to do the same with their own holdings.

Property prices can't rise forever; Beijing is trying hard to curb price appreciation and Chinese home ownership is already among the highest in the world. As many as 85% of urban Chinese families own property, according to the People's Bank of China report. Almost 19% of urban families already own more than one home.

Meanwhile, after a series of big ups and downs, China's stock market, as measured by the Shanghai Composite Index, is trading right where it was about a decade ago. The MSCI China Index, which tracks a basket of Chinese companies listed in mainland China and Hong Kong, is trading at 8.8 times expected earnings for the next 12 months, according to brokerage Daiwa Securities. Among Asian markets excluding Japan, only South Korea trades at a cheaper multiple. Markets in the Philippines and Indonesia are twice as expensive by that measure.

Chinese stocks are cheap compared with their history, too. They are trading at a 27% discount to their historical average price-to-earnings ratio. By comparison, stocks in Indonesia and the Philippines are both trading at premiums of more than 40% compared with their historical averages. China's steep discount looks excessive considering economic growth has remained solid.

"By any standard, China's GDP growth is still among the highest in the world, but stock valuations are among the cheapest in the region," said Mingchun Sun, Asia economist for Daiwa Securities. "Now is a good time to go against the crowd and take a more positive stance on China."

Liquidity has room for improvement. First, there is foreign money. Overseas investors would like to increase their stock investments in China.

For example, Norges Bank Investment Management, which manages the Norwegian Government Pension Fund, said it intends to apply for a larger quota to invest in Chinese stocks, after investing its current quota of $1 billion. The investment manager wants to further shift positions from European assets to emerging markets such as China.

Second, a lot of domestic money is still sitting on the sidelines. Chinese families put as much 58% of financial assets in bank deposits, followed by 18% in cash at home, 15% in stocks, and 4% in funds, according to the PBOC report.

The country's 77 mutual-fund companies have only $435 billion of assets under management, which equals about 5% of China's gross domestic product, according to Shanghai-based research firm Z-Ben Advisors. The U.S. mutual-fund industry has about $15 trillion in assets, roughly the size of the country's GDP, according to Strategic Insight.

ENLARGE

True, the Chinese stock market lacks a strong catalyst. Another big liquidity injection like the $600 billion government stimulus in 2009 looks unlikely. An expected reopening of the initial-public-offering floodgate will increase the supply of shares, potentially pushing down prices. Still, with valuations at current low levels, investors should think of smart ways to get into the market.

Instead of trying to pick winners among the 2,400 publicly traded companies, average investors are better off going with funds. Mom-and-pop investors play a big role in China, so professionally managed funds can often outperform the market.

One option is exchange-listed closed-end funds, which currently trade at prices that are 2% to 20% lower than the net asset values of their holdings. Unlike open-ended mutual funds, closed-end funds issue a fixed number of shares in an offering that then trade like stocks.

Most of the Chinese closed-end funds are set to become open-ended in the next year or two, at which time the discounts should disappear. Those who invest in the funds that will become open-ended in 2014 shouldn't lose any money even if the market falls another 5% in the next year, based on the current discounts.

That cushion looks attractive for investors who want to tiptoe back into Chinese equities.

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